Patent royalty rates: an element of surprise

12-05-2016

Ednaldo Silva

Patent royalty rates: an element of surprise

OLLYY / SHUTTERSTOCK.COM

After analysing data on royalty rates for pharmaceutical patents, some surprising characteristics can be observed. Ednaldo Silva of RoyaltyStat has more.

A large sample containing 3,704 unredacted pharmaceutical licensing agreements retrieved from the RoyaltyStat database in March 2016 reveals that sales-based pharma royalty rates have a stable 5% median, with an interquartile range from 3% to 10%. The frequency distribution of the royalty rates is skewed to the right, ie, it’s not normal.

An unredacted licensing agreement has the royalty rate and additional considerations such as upfront fees and milestone payments disclosed to the public. These agreements are submitted as “material contracts” to certain filings made by listed companies to the US Securities and Exchange Commission. We have separated patent agreements by sub-industry and “naked” (bare) deals from non-naked patent agreements.

The stability of the median pharma patent royalty rates persists when the data are divided by sub-industry. Table 1 shows that except for cardiovascular and gastrointestinal drugs, in which the median royalty rate is 6%, all the other drug types convey the same stable 5% median royalty rate.

table1-royaltystat.jpg

Naked patent agreements

A subset of 559 naked pharma patent agreements, in which only patent rights are conveyed, shows the same 5% median royalty rate. In Table 2, most unredacted agreements convey more than patent rights, including know-how and trademarks. Among the naked pharma agreements, 158 material contracts were filed in redacted form and we obtained the unredacted copy through freedom of information (FOI) requests.

table2-royaltystat.jpg

The FOI agreements show a 4% median royalty rate; such a small difference vitiates the need for a more elaborate statistical test for differences in central value between FOI and non-FOI agreements. Any claimed upward bias of royalty rates in redacted agreements is not supported by this data comparison.

In fact, no apparent factor appears to disturb the stability of the median royalty rates, considering exclusivity, duration, territory, rights to sub-license, tiered versus non-tiered rates, upfront fees, and milestone payments. These explanatory factors may influence the profit potential of the licensing agreements, but not necessarily the royalty rate. A claim that pharma royalty rates increase with the trial phase of the patents can’t be supported with information found in the licensing agreements reviewed.

Profit potential of licensed patents

The case Georgia-Pacific v United States Plywood, the OECD’s transfer pricing guidelines, and the US Treasury’s regulations on transfer pricing provide for the need to consider similar profit potential (expected future profits) from the patent licensing arrangement to establish the value of intangibles, including for patent damages.

In general, expected future profits are measured by net present value (NPV), whose reliability can be determined post-factum after actual profits can be compared with the projected amount. The selected (comparable or reasonable) royalty rate influences the NPV formula because it’s a determinant of the forecasted royalties to be discounted to the present.

The additional consideration is likely to exert a more complex influence on the profit potential of the patent portfolio because it is equivalent to a non-fixed intercept on the equation:

Royalties(t) = φ sales(t) + A(t), where φ ± δ (displacement) is the royalty rate (plus or minus a small variation), A(t) represents additional payments, and t = 0, 1, …, T is the expected future life of the royalties.

Present value(t) = SUM[α(t) (φ sales(t) + A(t))], where α(t) = (1 + d)−t is the discount factor and d is the discount rate, which may not be the capital asset pricing model.

Unlike a regression equation, the A(t) of equation (1) may not be constant, behaving like several parallel straight-lines with the same slope (royalty rate) coefficient and different intercepts, reflecting upfront fees at the start of the licence plus fixed milestone payments when product sales incorporating the licensed patent reach a certain level.

Exploratory review of a large sample of pharma patent royalty rates shows a stable 5% median and an interquartile range from 3% to 10%. Like other forms of income, the frequency distribution of royalty rates is asymmetric with certain dispersed long-tail outliers, so the average may not be a good representation of the mass of data.

A focus on a subset of FOI agreements shows similar royalty rate characteristics in terms of centre and spread, subverting a hypothesis that redacted agreements did not disclose the royalty rate when filed because they were higher than those of unredacted agreements. The median royalty rate is resilient to certain factors suspected to be influential, including exclusivity, tiered-structure, and territory. 

Additional considerations, including upfront fees and milestone payments, affect the NPV of the patent portfolio because these amounts influence (in specific forecasted periods) the total royalties expected from the patent licences. As a result, determining the profit potential of pharma patent licences requires consideration of the additional payments because the stability of the median royalty rate may mask total expected royalties.

Ednaldo Silva is founder and managing director at RoyaltyStat. He helped to draft the US transfer pricing regulations and wrote the comparable profits method called TNNM by the OECD. He can be contacted at: esilva@royaltystat.com

Ednaldo Silva, RoyaltyStat, OECD, NPV, patent, royalty rate, trademark, licensing agreement,

WIPR